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basic Keynesian expenditure multiplier. This model achieved fame through its exposition in Chapter 10 of Keyness General Theory, although Keynes points out that the
idea of the multiplier originates with R. F. Kahn (1931). Kahn and Keynes were
writing in the midst of the Great Depression, when major economies had extensive
unutilized productive capacity and prices were falling. This led to a set of assumptions that are unreasonable when applied to a normal economy near full employment, but that are more realistic in the context in which they were proposed.
The central point in Keyness analysis is the importance of what he called effective demand, and we now call aggregate demand. His model assumes that the
economys real output is determined principally (or in simple versions, solely) by the
quantity of goods and services that people want to buy rather than by the economys
capacity to produce. Any increase in desired expenditures is assumed to lead to an
1
increase in firms production, but not to any increase in prices. This assumption is
plausible for a depression economy, in a situation with high levels of unemployed
labor and underutilized plant capacity. But it would not be appropriate for an economy operating near or above capacity.
Under the assumption of perfectly elastic supply, any increase in spending on
domestically produced (i.e., not foreign) goods, whether from an increase in business
investment, government spending, or net exports, leads to an increase in output. The
Keynesian expenditure multiplier recognizes that this expenditure-induced increase
in output is simultaneously an increase in the incomes of those who produce the additional goods. Those whose incomes increase can be expected to increase their own
spending, leading to a second round of stimulus to output and income. This is, of
course, followed by a third round as those who produce goods that are newly demanded at the second round see rises in their incomes and choose to increase spending as a result, and by further rounds of spending increases ad infinitum.
Each successive round of increase in spending is smaller than its predecessor as
long as people spend only part of the increase in their incomes. Under simple assumptions (such as a constant marginal spending share that is less than one), the increments to spending of successive rounds die away to zero and the ultimate increase
in output, income, and spending approaches a finite multiple of the original increase
in spendingthe Keynesian expenditure multiplier.
Later in this chapter, we will characterize this assumption as a perfectly elastic short-run
aggregate-supply curve.
2-3
and we will also take investment and government spending as exogenous variables.
We can express the determination of output as
Y = C + I + G.
(1)
Recall that we are assuming that I and G are exogenous, and thus unaffected by
our other variables Y and C. We further assume that consumption depends positively
on income and that a one-dollar increase in income leads to less than one dollar of
increase in desired consumption.
C = + Y ,
(2)
with 0 < < 1. The coefficient in equation (2), which measures C/Y, plays a central in the multiplier; Keynes named the marginal propensity to consume.
Using equations (1) and (2) to tell the story we sketched above, suppose that either I or G goes up by $1,000. (It doesnt matter in this model which kind of expenditure increases, it could even be an increase in consumption through a change in the
coefficient.) From (1) we know that output and income will increase initially by
$1,000. But from equation (2), consumers will respond to this increase in their incomes by raising consumption by $1,000, which will again increase output and
income by a like amount.
Output has risen by $1,000 + $1,000 at this point, but we are not finished. In
the second round, consumers will increase spending by times the first-round increase in their incomes, or $1,000 = 2 $1,000, leading to a further rise in
income of this amount. This then leads to another rise in consumption and income of
3 $1,000, and then to an increase of 4 $1,000, and so on.
Eventually, the rise in income in the economy is
Y=
(1 + +
+ 3 + 4 + ...) $1,000.
(3)
The parenthetical expression in equation (3) is a geometric series; basic algebra tells
us that its sum is
1 + + 2 + 3 + ... =
1
,
1
thus
Y=
1
$1,000
1
2-4
(4)
1
. If the marginal propensity to consume (MPC) is 0.75,
1
then the multiplier is 1/0.25 = 4 and each additional dollar of investment or government spending eventually leads to four dollars of additional spending, production,
and income.
Y = + Y + I + G
(5)
Y Y = (1 )Y = + I + G.
Dividing by (1 ) yields the reduced-form solution for Y:
=
Y
1
( + I + G ).
1
(6)
Y Y
1
1
times as large. In terms of calculus, the multiplier is = =
.
I G 1
1
This is the same multiplier expression that we derived through the iterative, conceptual experiment leading to equation (4).
Desired
Expenditures
45-degree line
E
Y*
Y*
Income
2-6
Desired
Expenditures
45-degree line
E
E
Y
Y
Y*
Y*
Income
be much smaller, reducing the stimulative effect on output. However, in both the
Great Depression and the 2009 stimulus, interest rates were very low and did not
seem to rise when government spending rose.
The second crucial assumption is that firms respond to increased demand solely
by raising output. We argued above that this assumption was reasonable (at least as a
first approximation) during the Great Depression, but firms that are near their optimal production capacity are likely to respond to a rise in demand by increasing their
prices more than by increasing output. If this happens, then the stimulative effect of
increased government spending will be dissipated on price increases rather than expansion of real output. We shall see this later in this chapter when we discuss the
slope of the aggregate-supply curve and its effect on the responses of output and prices to changes in aggregate demand.
In the recent recession, the magnitude of fiscal-policy multipliers was a controversial and heavily studied topic. Three articles in the September 2011 issue of Journal of Economic Literature provide a good sample from different ideological and methodological perspectives: Taylor (2011), Parker (2011), and Ramey (2011).
Expenditure multipliers are also often used by urban economists to analyze the
secondary effects of activities that boost local spending, such as a large public-works
project, the movement into the area of a large new plant, or the creation, attraction,
or retention of a new professional sports franchise. In each case, expenditures by
those who earn income from the initial activity lead to secondary income effects.
However, to evaluate local effects, one must be careful to restrict the MPC to include
only income-induced expenditures on local goods and services.
whether asparagus should be expensive or cheap relative to other goodsthe relative price of asparagusbut it could not tie down that price in absolute dollar terms.
What was required to fill in this missing link was to determine the value, or price,
of money in terms of goods, which is the reciprocal of the price of goods in terms of
money, which we call the general price level. Given that supply and demand analysis determined the value of all of the other goods in the model, it made sense to consider the supply of and demand for money as determinants of the value of money.
Before proceeding to discuss the supply and demand for money, we must clarify
2
that money is a stock rather than a flow. When we talk about the supply of money
we are talking about the current available stock of whatever monetary assets are used
in the economy. For example, if money is just dollar bills, the supply of money is the
total number of dollar bills that are held in the economy at a moment of time: add up
the number in your wallet and the wallets and cash drawers of all of the households
and firms in the economy. Similarly, the demand for money is the amount of its total
stock of wealth that households and firms want to hold in the form of the monetary
asset. When thinking of the demand for money we should think in terms of our desire to hold cash vs. other kinds of assets such as bonds, stock, or physical assets.
In later chapters we shall examine in more detail the characteristics of the assets that we
classify as money and what assets have those characteristics.
2-9
Equation of exchange
The central mathematical expression of the quantity theory is the equation of
exchange: MV = PY. Both sides measure total nominal (dollar) transactions in the
economy, so the equation is a tautology that must always hold. To make it a theory,
we add assumptions about the causal relationships among the variables.
The right-hand side of the equation PY is the product of the price level and real
GDP, which is just nominal GDP. This is the dollar value of all final goods and services produced and purchased in the economy during the yearthe dollar value of
all final transactions.
The left-hand side is the product of the money stock, which is assumed to be exogenous, and the income velocity of money V. Income velocity is the number of
times that the average dollar in the economy is spent on final goods and services dur3
ing a year. The product of the number of dollars times the number of times the average dollar is spent during the year must equal the total volume of dollar spending, so
MV always equals PY by construction.
Because M is a stock and PY is a flow, velocity must be doing something to translate between stocks and flows. To see how this works, consider the units in which the
variables are measured. Y is a flow of goods per year and P is the price level measured in dollars per good, so the measurement unit of their product is dollars per year.
The money stock M is measured in dollars, with no time unit at all. Velocity is a
number of times per year, so its units are 1/years. Multiplying M by V converts it
from a stock to a flow with units of dollars per year, matching the units of the righthand side.
Velocity reflects (inversely) peoples demand for money, given their transaction
flow. A higher velocity corresponds to making a given quantity of money perform
more transactions, so high velocity reflects a low desire to hold money. We can represent the nominal demand for money in the equation of exchange as
Md =
PY
,
V
(7)
so the equation of exchange shows how velocity and transactions volume work to
determine how much money people want to hold.
We must make sure that the collection of transactions that are counted on the left-hand side
matches the collection counted on the right. Because Y includes only final goods and services,
we use income velocity on the left rather than the more intuitive transactions velocity,
which would count monetary expenditures on intermediate goods as well as final goods.
2 - 10
P=
MV
Y
(8)
with the variables on the right-hand side all being determined independently.
The principal implication of the quantity theory is that money is neutral, which
means that changes in the nominal quantity of money lead to proportional increases
in prices (as well as wages, nominal exchange rates, and any other dollar magnitudes
in the economy) and leave all real variables such as output and employment (and
the real wage, measured in terms of purchasing power) unchanged. In terms of elasticities, the elasticity of the price level with respect to the money supply is one and
the elasticity of output with respect to the money supply is zero.
2 - 11
2 - 12
Keynes pointed out many of these factors in the General Theory, but did not integrate them mathematically. The Keynesian consensus of the 1940s through 1960s
formed around a simple version of the Keyness analysis developed by Sir John
Hicks (1937). Hickss simple model leaves out much of the detail of Keyness complex and nuanced (if often ambiguous and seemingly contradictory) text, but Keynes
himself allegedly acknowledged that Hicks had faithfully captured the most essential
characteristics of his theory. Axel Leijonhufvud (1968) provides a detailed comparison of the IS/LM model and other Keynesian models with the theory of Keynes,
as exposited in the text of the General Theory.
The income-expenditure model of section B is embedded in the IS curve of the
IS/LM model. Instead of taking investment spending as an exogenous variable, the
IS curve models it as depending on the real interest rate. This brings the interest rate
into the model as a second endogenous variable (alongside income), which requires
us to add a second equation to explain how interest rates relate to real output.
Although the IS/LM model generalizes the income-expenditure framework to a
limited extent, it still models income-determination strictly through aggregate demandfirms are assumed to produce whatever amount of output people want to buy
at a fixed price level. After we examine the IS/LM framework in this section, we will
explore briefly how a more realistic theory of aggregate supply can be combined with
aggregate demand in a more general model.
nominal interest rate. One can put either the real or nominal interest rate on the vertical axis, but in either case one of the curves must be adjusted to account for the expected rate of inflationthe difference between the nominal and real interest rates.
There is no standard among textbooks about which convention to use; many inferior
texts ignore the distinction entirely. In this analysis, we will use the real interest rate r
on the vertical axis.
Hickss derivation of the IS curve used investment = saving as the condition for equilibrium;
we have used income = expenditures. Ignoring government, Y = C + I is our condition for
income = expenditures. Since households allocate their current income between consumption
and saving, Y = C + S. Setting these two equations equal to one another, equilibrium between
expenditures and income can also be written as I = S, which is the form used by Hicks, leading him to call the resulting curve the IS curve.
2 - 14
Government expenditures. An increase in government expenditures (holding taxes constant) raises the demand for goods and services directly, pushing
the desired expenditure curve up and the IS curve to the right. This effect
might be mitigated to some extent by reductions in private spending if (1) the
goods that the government buys are direct substitutes for consumer spending
(for example, police for private security or school lunches for parent-provided
food), or (2) households anticipate (as in the Ramsey and Diamond growth
models that we will study in Romers Chapter 2) that the rise in government
spending will lead to increases in future taxes, causing them to reduce consumption expenditures to set aside money for their future tax obligations.
Taxes. An increase in taxes (holding government spending constant) should
lower private spending, pushing the desired-expenditure curve downward
and the IS curve to the left. Again, we shall have more to say about this when
we study the Ramsey and Diamond models. If households behave strictly according to lifetime-utility maximization and other special conditions hold,
then they will recognize that government borrowing today must be repaid by
higher taxes in the future. This situation is called Ricardian equivalence,
and if it holds perfectly, then the timing of taxes will be irrelevant and changes in todays taxes would not affect private spending. However, there are
many reasons to be skeptical about Ricardian equivalence and most
Keynesians ignore this possibility.
Optimism about the future. If expected future income were to increase,
households lifetime budget constraints would shift outward, leading them (to
the extent that credit markets allow them to borrow against the higher future
income) to increase current consumption. Expectations of future demand
may also have a strong effect on firms capital-investment decisions because
many capital projects have long gestation lags between the time the decision to invest is made and the time that the new plant is put into production.
Optimism about future demand (Keynes famously called these expectations
animal spirits) affects expected future production, which drives the need
for capital in the future.
More detailed models of consumption and investment spending are the subject of
Romers Chapters 8 and 9, and are discussed in Chapters 15 and 16 of the coursebook.
could use the IS curve to figure out what the equilibrium Y must be, or vice versa. But
in order to determine the levels of both variables, we need a second equilibrium relationship. We seek the needed relationship by examining the equilibrium between the
stock supplies of monetary and non-monetary assets and the demand for these assets.
The traditional way to characterize the asset-equilibrium relationship is the LM
curve, describing the conditions leading the quantity of money demanded by households and firms to equal the quantity supplied by the central bank and the financial
system. Since the demand for money depends on the interest rate (negatively) and
income (positively), there are many alternative combinations of r and Y for which the
demand will equal any given level of money supply. This upward-sloping collection
of (Y, r) pairs is the LM curve.
The LM analysis was developed to describe a financial system in which the time
path of the money stock is exogenously determined by the institutions of monetary
supply, either through the rules of the gold standard or by the decisions of a central
bank that sets a target level or growth rate for the money stock. Under such a regime,
the short-term interest rate adjusts in order to balance endogenous money demand
with the exogenous quantity supplied.
The IS/LM analysis has fallen out of favoreven among Keynesian macroeconomists who do not object to the absence of microfoundationsbecause most
modern central banks no longer set monetary policy according to money-supply or
money-growth targets. Instead, most now follow policies that target a specific shortterm interest rate and allow the money supply to adjust to whatever level achieves
5
balances asset markets at the desired interest-rate target. This makes the money supply endogenous and suggests that we should model the central banks decision rule
for setting the interest rate as our second curve. We shall study a variant of this kind,
the IS/MP model, when we get to Romers Chapter 6. For now, we explore the historically important IS/LM model.
If the income velocity of money is constant, as we assumed in the quantity theory, then the nominal demand for money is given by equation (7). But Keynes (and
some classical economists before him) noted that the interest rate should affect the
share of peoples wealth that they want to hold in the form of money. In the simplest
setting, bonds (and other assets) bear interest at real rate r and nominal rate i = r + ,
where is the rate of inflation (actual or expected, we do not distinguish between
them here for simplicity). Moneythink gold or currency herebears zero nominal
interest, and its real return is ; moneys real value depreciates at the rate of inflation.
The Federal Reserve Board in the United States last followed a strict monetary rule between
1979 and 1982. Since then, interest-rate targets have been more important.
2 - 16
The difference between the rate of interest on bonds and the rate of interest on
money is the opportunity cost of holding wealth as money rather than as bonds. This
6
difference equals the nominal rate of interest on bonds. A higher nominal interest
rate should cause households to economize on money holdings (choosing to shift
wealth into bonds), turning over their dollars more quickly in order to make their
needed transactions. In other words, when the interest rate rises people will increase
their velocity of money.
We can incorporate this effect into equation (7) very simply:
Md =
PY
,
V ( r + )
(9)
where V ( r + ) is velocity written as a function of the nominal interest rate with the
assumption that V ( r + ) > 0 . Equation (9) is usually rewritten in terms of the demand for real money balances M/P. Dividing both sides by P yields
Md
Y
=
L (Y , r + ) ,
P
V ( r + )
(10)
Ms
Y
.
=
P V ( r + )
(11)
The difference between the nominal returns on bonds and money is i 0 = i. The difference
between the real returns is r () = i + = i. Thus we get the same answer whether we
calculate the difference between bonds and money in nominal returns or real returns.
2 - 17
Whereas the IS curve was shown to slope downward, we can easily demonstrate
that the LM curve must slope upward. Suppose that income in the economy were to
increase. This would mean more real transactions and would induce people to want
to hold greater money balances. (The right-hand side of (11) would increase.) With a
given supply of money and a given price level, the only way to rebalance equation
(11) would be through a change in r. To offset the increase in money demand arising
from higher income, the interest rate would have to increase in order to raise velocity
so that the denominator of (11) rises to match the increase in the numerator. Thus,
the LM curve must slope upward: other things held constant, an increase in real income requires an increase in the interest rate in order to rebalance money demand
with money supply.
LM(M/P, )
r*
IS(G, T, Ye)
Yd
Figure 3. IS/LM equilibrium
2 - 18
Effect
on IS
right
left
right
none
none
none
Effect
on LM
none
none
none
right
left
down
Effect
on Y
+
+
+
Effect
on r
+
goods, so there is nothing obvious to substitute for GDP if it gets expensive. Thus,
in the macro context we cannot rely on the familiar logic of substitution to motivate
the negative slope of the demand curve.
The price variable P on the vertical axis is also fundamentally different. In the
AS/AD model, price refers to the aggregate price of all goods and servicesa price
index like the GDP deflatorrather than the relative price of zucchini as in the micro
model. Again, this has important implications for the behavior of the curves. An increase in all prices may not have any effect on either quantity supplied or quantity
demanded if, along with the increase in prices, nominal wages and nominal stocks of
assets such as money all increase in equal proportion. This is the familiar principle
that the economy exhibits no money illusionpeople care only about the real value of
things, not about the number of dollars attached to them. If all dollar labels are redefined in a proportional way, nothing is more or less expensive than before and there
is no reason for real purchases or sales to change.
Future goods and foreign goods are possible substitutes. Well have more to say about such
issues later on.
2 - 20
unique equilibrium level of output and prices. This is the most common form of the
model and is adequate as a momentary snapshot of the macroeconomy.
However, modern economies typically exhibit year-to-year growth in real output
and year-to-year inflation in the price level rather than levels that stay constant over
time. We are often more interested in these rates of change than in the absolute level
of GDP and prices. To capture this ongoing behavior in the levels version of the
AS/AD model, the equilibrium point would be moving upward and to the right
8
over time. We can keep the model in terms of levels only if we are willing to discard
the notion of a fixed point of long-run equilibrium and depict the long run as an equilibrium growth/inflation path involving a sequence (or continuum) of points of momentary equilibrium.
An alternative modeling strategy is to put the growth rate of output on the horizontal axis and/or the inflation rate on the vertical axis, modeling aggregate supply
and aggregate demand in terms of percentage changes rather than levels of output
and/or prices. By recasting the model in terms of rates of change, the economy may
converge to a single point of long-run equilibrium on the graph: one where the
growth rate of output and the rate of inflation are constant.
However, there are difficulties with casting the model in rates of change as well.
Putting the graphical analysis entirely in terms of growth rates means that there is no
information on the graph about the level of output. Suppose that last years growth
rate was unusually low, so the current level of output in the economy is below its
long-run growth trend. Conventional macroeconomic theory suggests that such an
economy would be expected to grow more quickly in the coming years to recover
toward the trend path. On the graph, this means that aggregate supply or aggregate
demand (or both) must shift to the right when output is below trend in order to increase growth. In order to incorporate this into the graph, the position of the AD and
AS curves must depend on the current level of GDP relative to a benchmark trend.
We shall model aggregate supply and demand in levels rather than growth rates.
In the simple model that we introduce first, we ignore the tendency of output and
prices to grow over the long run. Later in this chapter we will consider the nature of
equilibrium behavior with growth and inflation.
In competitive microeconomic markets we use the supply curve and the demand
curve to represent, respectively, the behavior of the producers and buyers of a commodity. By examining the interaction of the two curves and imposing an assumption
that the price adjusts to clear the market, we model the equilibrium levels of quantity
exchanged and price at the intersection of the two curves.
The aggregate supply (AS) curve and aggregate demand (AD) curve perform similar roles for the aggregate macroeconomy. The AS curve summarizes the behavior
8
Or downward in the case of deflation and to the left in the case of economic contraction.
2 - 21
of the production side of the market: production decisions of firms and activities in
the markets for factor inputs. The AD curve summarizes desired purchases in the
macroeconomy and activities in asset markets that influence demand behavior.
Like microeconomic supply curves, the AS curve often slopes upward, though
the underlying logic justifying its shape is quite different. The AS curve is horizontal
or vertical under some conditions. Unlike microeconomic supply curves, which tend
to me more elastic in the long run than in the short run, the AS curve is perfectly inelastic (vertical) in the long run and may be highly elastic (flat) in the short run.
The AD curve is generally downward-sloping, just as the microeconomic demand curve is, but again the reasons for the negative slope and the conditions under
which it is elastic or inelastic are quite different.
2 - 22
Of course, this assumes that there is no change over time in the determinants of natural output. If the labor force and capital stock increase and technology improves, then we expect the
natural level of output to increase, which will mean that the long-run AS curve is not stationary but instead shifts to the right over time. Thus, the long-run AS curve is long-run in the
sense that the economy moves toward it in the long run, but not in the sense that it remains
stable in the long run.
2 - 23
There are multitudes of theories explaining why the short-run AS curve might
slope upward. We will study several of these theories in Romers Chapter 6, so there
is no need to elaborate the details now. A couple of examples should demonstrate the
nature of elastic short-run supply.
One possibility is that firms face costs of changing their prices. These costs are
often called menu costs, as in the costs a restaurant faces when it must reprint
menus to reflect changed prices. In that case, if there is upward pressure on nominal
prices due to an increase in aggregate demand, some firms may choose not to raise
their prices immediately, even if other firms do raise their prices. The relative prices
charged by the firms that do not raise prices will be lower than before and they will
sell more output as a result. Thus, in the presence of menu costs, some firms will
raise prices and others will increase production, so in the aggregate there will be an
10
increase in both prices and output along an upward-sloping short-run AS curve.
Note that in this case we would expect all firms eventually to change their prices (once
the old menus wear out), so the justification for an upward-sloping AS curve holds
only in the short run. Even with menu costs, we still expect the long-run response to
be an increase in all nominal prices with production back at Yn, so the long-run AS
curve is vertical.
Another possibility is that some of the firms nominal costs fail to rise along with
prices. For example, if wages are set for a period of time by nominal (fixed-dollar)
contracts, an increase in prices (assuming no menu costs) would temporarily raise the
firms revenues relative to their (labor) costs. This would make it profitable to expand
output in the short run while this positive gap between revenues and costs exists.
Once again, production increases and prices rise in the short run, so the short-run AS
curve slopes upward. However, as in the previous example, we would expect production eventually to return to Yn at the higher price level. In this case, nominal wages
would rise when contracts expire and workers whose cost of living has increased bargain for a compensating wage increase. Thus, again, the long-run AS curve is vertical.
10
Note also that we have already strayed from one of the key assumptions of the PCGE model. A price-taking firm in a perfectly competitive market cannot defer its price change; it must
charge the market-clearing price. If a few firms kept their prices low in a perfectly competitive
market, all buyers would attempt to buy from them, forcing them to increase production
dramatically, which would increase costs and force them to raise prices.
2 - 24
above: (1) the short-run AS curve slopes upward and (2) the long-run AS curve is vertical at Yn.
A third property that connects the short-run and long-run supply curves is less
obvious: the short-run AS curve passes through the vertical long-run AS (Y = Yn) at
the expected price level. Thus, the point (Yn , P e ) always lies on the short-run AS curve.
We can explain the logic of this fixed point on the AS curve for the two simple
models discussed above. With menu costs, we assume that the prices that firms have
set for this period (and printed on their menus) are those that they expected to prevail
at the time the menus were printed. Thus, if aggregate demand turns out to be as expected, firms will have set the appropriate prices and the economy will be in PCGE
with P = Pe and Y = Yn. In the case discussed above, AD is higher than expected,
leading to P > Pe and Y > Yn.
In the wage-contract model, we assume that firms and workers try to set the
nominal wage in a way that leads to the PCGE real wage (W/P)*. If they expect the
price level to be Pe, then they set the nominal wage at W= P e (W / P ) * . If aggregate
demand is as expected and the price level actually turns out to be Pe, then the actual
real wage will be W / P e = (W / P ) * and the economy will be in PCGE. If aggregate
demand is unexpectedly high and the price level exceeds Pe then the real wage will be
lower than (W/P)* and firms will expand production.
To summarize the conventional properties of aggregate supply, as depicted in
Figure 4:
The long-run AS curve is vertical at Y = Yn. In the long run, changes in aggregate demand affect only the price level and not the level of real output.
The short-run AS curve slopes upward and passes through the point where
Y = Yn and P = Pe. In the short run, increases in aggregate demand lead to increases in both price and real output.
2 - 25
LRAS
SRAS
Pe
Yn
Aggregate demand
The aggregate-demand curve summarizes the desired spending behavior of consumers, firms investing in durable plant and equipment, governments, and (in an
open economy) foreigners. There are many ways to model aggregate demandthe
income-expenditure model, IS/LM model, and quantity theory equation are three of
the most common. In many of our more complex models later in the course we use a
simple place holder for AD and focus on the details of aggregate supply. The closer focus on aggregate supply is because alternative aggregate-demand theories tend to
have similar outcomes whereas the supply side has been highly controversial.
Aggregate demand rises when households, firms, and governments decide to increase their expenditures. There are many reasons why this could happen: increased
optimism by households about their lifetime incomes, increased optimism by firms
about their need for plant and equipment, stimulative fiscal policy that increases government purchases directly or lowers taxes to stimulate private spending, a depreciation of the dollar that makes domestic goods cheaper for foreign buyers, etc.
In macroeconomics, emphasis is often placed on the effects of monetary conditions and monetary policy on aggregate demand. As we shall discuss briefly later in
the course, an expansionary monetary policy involves the central bank (the Federal
2 - 26
Reserve System in the United States) increasing the supply of monetary assets and, in
the process, driving down nominal interest rates on very-short-term loans between
financial institutions.
The combination of more plentiful monetary assets and lower interest rates tends
to stimulate households and firms desire to spend. In the simplest sense, households
that find that they hold additional wealth in the form of monetary assets may simply
spend some of it. More subtly, if the reduction in the nominal interbank rate targeted
by the central bank diffuses through the market to lower real rates on the interestbearing assets bought and sold by households and firms, then monetary policy may
act through an interest-rate channel. Lower (real) interest rates encourage spending
by reducing the reward to saving and lowering the cost of home mortgages, car
loans, and student loans. For businesses, lower real interest rates reduce the cost of
borrowing to invest in plants and equipment.
2 - 27
AD
the LM curve would not move and there would be no change in output demanded.
In graphical terms, this means that the new AD curve after the 5% increase in the
money supply must be shifted upward by exactly 5% at each level of Y. Figure 6
shows this effect. If M increases from M0 to 1.05M0, then if Y stays the same, the
equilibrium level of P must increase from P0 to 1.05P0.
11
The leftward shift in LM due to the increase in P exactly offsets the rightward shift due to
the rise in M because the LM curves position depends on M/P.
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5% increase in P
1.05 P0
P0
AD(M=1.05M0)
AD(M=M0)
Y
Figure 6. Effect of 5% increase in money supply on AD
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general indicator of aggregate demand, incorporating both monetary policy and all of
the other factors that might reasonably determine the position of the AD curve.
Static equilibrium
It is probably obvious that the short-run equilibrium of the economy occurs at the
intersection of the aggregate demand and short-run aggregate supply curves and that
the long-run equilibrium is where the aggregate demand curve intersects the long-run
aggregate supply curve. The situation depicted in Figure 7 shows a state of long-run
and short-run equilibrium at point e. If the aggregate demand curve and aggregate
supply curves were to remain unchanged, the economy would continue to produce
Yn and have a price level of Pe indefinitely.
However, as noted above, there are many reasons why the AD and AS curves
could shift. In the next section, we consider ongoing changes such as steady growth
in natural output and sustained inflation. Here we examine one-time changes as perturbations from a static equilibrium such as a point e.
LRAS
SRAS
Pe
AD
Yn
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12
We begin all of our experiments from an initial point of long-run equilibrium. This allows
us to examine the short-run and long-run effects of the shock without interference. If we
were to begin from any other situation, two separate effects would be occurring at the same
time: (1) the natural adjustment process from the initial situation to long-run equilibrium,
which would have occurred in the absence of any shock, and (2) the effects of the shock. Beginning from full employment sometimes seems counterintuitive when the shock in question
is a change in macroeconomic policy, since expansionary monetary and fiscal policy is usually used when the economy is believed to be operating below the natural level of output.
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LRAS
SRAS
P2
P1
Pe
SRAS
e
AD
Yn
Y1
AD
Was the 2008 financial-market disruption that curtailed many firms access to financial capital a supply shock or a demand shock? The monetary and financial system is usually modeled as part of the demand side but constraints on the ability of firms to produce are supply
shocks. One can think of both kinds of effects occurring in 2008.
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increase in natural output) and price falling to P1. At e the economy is actually below
its natural output, but it is unlikely that policymakers or the general public would
easily recognize this gap because Yn is not directly observable and the absolute level
of output has increased.
In the long run, the expected price level will adjust downward following the decline in prices. The eventual equilibrium of the economy will occur at e, with price
falling further to P2 and real output increasing to the new natural level.
The one-time shocks depicted in Figure 8 and Figure 9 are interesting and they
illustrate the short-run and long-run effects of demand and supply shocks. However,
they are unrealistic in one important way: the economy in which they occur has neither ongoing growth in natural real output not inflation of the price level.
Since output in nearly all modern economies is growing over time and inflation
is a common phenomenon in most, we should also examine how the AS/AD model
can be used to demonstrate the equilibrium evolution of such economies. We now
turn to that task.
LRAS LRAS
SRAS SRAS
Pe
P1
P2
e
e
AD
Yn Y1 Yn
Figure 9. Effects of an aggregate supply shock
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LRAS2
LRAS1
LRAS3
SRAS1
SRAS2
SRAS3
P3
P2
P1
2%
2%
e3
e2
e1
5%
3%
3%
Yn,1
5%
Yn,2
AD2
AD1
Yn,3
AD3
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A growth recession
The dynamic equilibrium diagram of Figure 10 can also be used to show the effects of a slower-than-expected growth in aggregate demand. Suppose that the equilibria in periods one and two are as shown at e1 and e2 in Figure 10, which are replicated in Figure 11. Everyone expects that aggregate demand in period three will continue to grow at 5 percent, as shown by AD3e in Figure 11. However, suppose that in
period three the central bank reduces money growth from 5 percent to 3 percent in an
effort to eliminate inflation. This means that the actual aggregate demand curve in
period three is at AD3, below the expected level.
Since inflation expectations were formed based on the expected AD curve AD3e,
expected inflation is still 2 percent and the expected price level is P3e. This means that
the SRAS curve still shifts to SRAS3 based on the 2 percent expected inflation. However, since actual aggregate demand is AD2, the equilibrium of the economy in period three is at e3 in Figure 11, with output Y3 lower that the natural level Yn,3 and prices still rising somewhat to P3, but rising less than the expected inflation rate of 2 percent.
LRAS2
LRAS1
P3 e
P3
P2
P1
LRAS3
SRAS1
SRAS2
SRAS3
SRAS3*
2%
2%
e3
e2
e1
e3*
5%
5%
3%
AD2
AD1
3%
3%
Yn,1
Yn,2
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Y3 Yn,3
AD3e
AD3
14
In a famous article, Laurence Ball (1994) has estimated the sacrifice ratiothe amount of
forgone output for each percentage-point reduction in inflationfor late 20th century disinflations.
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models all describe the evolution over time in the natural level of output, ignoring
any role of aggregate demand.
The emphasis in these models is on increases in aggregate supplies of labor and
capital resources and on technological progressi.e., on the supply side of the macroeconomy. By focusing exclusively on aggregate supply, these models ignore any
demand-related fluctuations of output relative to its long-run equilibrium growth
path, such as those in Figure 11.
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zation of the macroeconomy would use these models to explain the AD curve, then
combine them with theories of aggregate supply.
2 - 40